How To Use Debt the Right Way
When the word “debt” comes to mind, you might have a negative reaction. After all, so much financial advice is devoted to getting people out of it. With debt levels hitting new records each year, it’s easy to see debt as something to avoid at all costs.
But is debt always a bad thing? While it can be financially devastating if taken on irresponsibly, depleting funds and increasing a loan balance over an extended period, using debt strategically can be a way to achieve both short and long-term financial goals.
In this comprehensive guide, we will cover the benefits of debt along with everything you need to know on how to use debt the right way to build your wealth.
The Different Types of Debt
For the average American, debt is just a part of life. By the end of 2021, total debt reached a staggering $15.58 trillion.
While rising debt is still a cause for concern, it’s important to note that not all debt is the same. Getting into debt irresponsibly through reckless spending or unnecessary purchases can get you into serious financial trouble. The right kind of debt, though, can be a wealth-building tool, as long as it’s managed properly.
Experts break down debt into two categories: good and bad. Here are the different types of debt and how to distinguish between the two.
Good Debt
The concept of “good” debt can be hard to fully understand. Essentially, it takes money to create more money. That's why good debt is the kind of debt that helps you generate income or grow your net worth.
For example, a student loan could be an example of good debt. While it puts you into debt, the payoff is an education that can help you land a high-paying job. The same goes for loans like mortgages or business loans, which offer significant value. You’ll still have debt to pay off at the end of the day, but the loans you take can create value, essentially paying for themselves over time.
Good debt calls for responsible financial planning, though. A business loan might seem like good debt until your business venture falls through before you get a chance to see a return on your investment. Or an education loan might seem like a good idea, except you’re investing in a degree with few job openings or a low salary. It still takes research and planning to use good debt the right way, including taking on the right loans and holding yourself accountable to a payment plan.
Bad Debt
When the topic of debt comes up, bad debt is what most people think about first. Bad debt includes any high-interest consumer debt that doesn’t play a role in your long-term financial goals.
For example, carrying a high-interest credit card and using it recklessly is an example of bad debt. Many people carry a credit card for convenient spending on clothes, furniture, food, and gas, but it’s important to pay off the balance at the end of every month — just paying the minimum isn't enough.
Auto loans are another example of bad debt. Many auto loans carry lengthy terms, and the car you just bought has likely already depreciated in value the moment you left the lot.
Essentially, bad debt is the kind of debt that loses value. With a steep interest rate, you could end up paying more than the asset is worth over time.
How Can You Use Debt To Create Real Wealth?
Most people know what accumulating “bad” debt can look like — getting in over your head, spending years paying the bare minimum, scraping together enough for monthly payments to the point where you don’t see a way out. That's why many prefer having insufficient debt — even the good kind — rather than tons of it.
Looking at the consequences of mismanaging debt, it’s no surprise that many people are cautious about taking on loans. But what if debt could work for you rather than against? What if you could learn how to use debt as money?
When you use good debt the right way, you can leverage the power of your money to grow your wealth. It just takes the right strategies to learn how to use debt to build wealth. Here are all the ways you can manage your money to make the most of your debt.
1. Practice Debt Recycling
One way to convert debt into wealth is by practicing debt recycling. Most forms of debt are inefficient, which means they don’t generate capital growth or income. Most aren’t tax deductible either.
Debt recycling is the process of converting that debt into something more efficient. One way to do this is by using a lump sum to pay off your inefficient debt right away. If you then borrow the same amount of money and invest it, you can replace inefficient debt with the more efficient kind, which gives you the potential to generate wealth.
2. Use Debt To Invest in Cash Flow Planning Opportunities
While some people borrow to afford university tuition or a new car, there are other ways to invest that can offer a more powerful return. Borrowing to invest means taking on debt as a means to build wealth over time.
Whether you’re investing in property or shares, these investments can increase in value over time. This capital growth and income can be used to pay back the debt, including interest, while still making a profit.
However, just like any form of investment, this brings risk. If your investments decrease in value, you could end up owing more than the loan you took out.
3. Remove Bad Debt
Taking out good debt from the start is the best way to get on track toward long-term wealth. But that isn’t always a possibility for everyone. Maybe you’ve already taken out loans, or you needed something last minute and didn’t have a chance to look over the terms.
If you have debt associated with high interest or other fees, it can help to focus on paying off this debt first. Dedicate yourself to progressively paying off your least efficient debt first, so you can focus on making your more efficient forms of debt work in your favor.
4. Take Out Personal Loans To Consolidate Debt Payments
Another way to manage debt is to consolidate it through a personal loan. Debt consolidation loans don’t eliminate debt, but they can restructure it in a way that’s more financially favorable, with a lower interest rate. Taking out a consolidation loan can also lower your utilization rate, improving your credit score.
While you’ll still be paying back what you owe, you can do so under much better terms.
What Are the Benefits of Borrowing?
Taking on extra debt can be a source of stress for most people. All money gained from loans comes at the cost of interest. Borrowing too much could leave you in a serious financial crisis.
Borrowing the right way, however, can bring long-term benefits that go far beyond your initial investment. Taking out a loan can be a powerful tool for growth, whether you're growing your business or just want to stabilize your financial situation.
The thought of taking on debt can be intimidating, but it doesn't have to be. Here are some of the benefits of borrowing money.
Convenience
There's a reason why so many people turn to credit cards when purchasing necessary goods: it's a convenient way to shop. All you have to do is put your purchases down on a card, without worrying about your bank account balance, and pay the amount off later. Some credit cards even offer incentive points to reward their users, from cash back to airline miles.
When your business is in the early growing stage, you may need resources to put your plans into action. Instead of struggling to save up money or relying on outside grants, borrowing money is a convenient way to achieve your goals.
Without the option of borrowing, huge life choices — like opening a business or attending college — could be out of reach for so many people. Countless entrepreneurs wouldn't have been able to build their business, let alone pull in high earnings. Debt evens the playing field, allowing anyone to reach their financial aspirations.
Builds Credit
If you want to improve your credit score, borrowing money might be the last thing you think you should do. But borrowing money from the bank can improve your credit score, depending on your debt situation.
Opening a line of credit and making all your payments on time will help you maintain a good credit score, no matter how much you take out. As long as you don’t miss any payments, your credit score will improve eventually.
Once you’ve built a stronger credit score, it’s easier to make bigger investments, including bigger loans with better interest rates.
Tax Benefits
When it comes to debt, there’s no shortage of tax breaks you can benefit from. You can deduct the interest paid on mortgages, home equity loans, student loans, and small business loans. The more interest you've paid, the greater the deduction you'll have on your next tax return.
Even if you take on debt to make taxable investments, this could also save you money. The interest on that debt can become "investment interest," which can become a deduction on your taxes.
Strategies To Reduce Debt Levels of Unsecured Debts
No matter what strategies you take, paying off debt isn’t an easy task. Paying the minimum each month won’t get rid of your credit card balance — it’s more likely to keep you trapped in a cycle of debt burdens.
Debt can be an effective investment tool, but only if it's used the right way. If you've found yourself with more debt than you can handle, it's time to start paying it off as quickly as you can. The longer you wait, the more you'll end up paying in interest.
When trying to reduce debt levels, there are two distinct strategies you can take: the snowball method and the avalanche method. There are pros and cons to each option, but both accelerate payments to help you get clear of debt once and for all. Let's compare the ways each method can help you learn how to reduce debt.
Snowball Method
With the snowball method, you pay off your smallest debts first. Then you take the amount used to pay your first debts to pay off your larger debts, rolling the money along like a snowball down a hill.
To do the snowball method, first make sure you have enough money saved up to cover the minimum monthly payment for your loan. Then, arrange all of your debts, from the smallest balance to the largest. Don’t think about the interest rates, but instead just focus on the total amount you have left to pay.
Each month, put the extra money you saved toward your smallest debt. Once that debt is paid, take the amount you were already paying (the monthly minimum on top of the extra money you have saved) and put it towards your next debt. Every time you free up more money, you put it towards the next debt.
Pros
This strategy may not seem like the most efficient. After all, it means paying off debts that may have lower interests first while letting other loans collect interest. But many find the snowball method easier to tackle. Each payment comes with a feeling of satisfaction and victory. This, along with the extra money that comes with cutting down on smaller debts, creates momentum that makes it easier to stick to a payment plan.
The snowball method works best for someone who might be struggling to pay off their debts. If you find it motivating to see debt paid off, card by card, and need some encouragement to stick to the plan, you might find success with this method.
Cons
While the snowball method can be easier to handle, it doesn’t come without cons. The snowball method can take longer than the other methods to pay down your debts. Most importantly, it can cost more money over time, as you’ll be paying more in interest. If you have bigger loans with high interest, it may not be worth it to put those debts off until later.
Avalanche Method
Unlike the snowball method, the avalanche method is designed to tackle the worst of your debt all at once. With the debt avalanche method, you eliminate your highest interest debt first. Once that card is paid off, you move on to the debt with the next highest interest rate. Meanwhile, you keep paying the minimum amounts on all your other debts.
Just like the snowball method, you can take the minimum amount you were paying each month on top of your additional savings. This helps the payments accelerate, taking on your debt as quickly as possible.
That’s also why it’s known as the “avalanche” method: higher interest rate debt crashes down quickly, followed by the smaller debts going down the mountainside.
Pros
Using this strategy, you can clear all your debts in a way that minimizes the total interest you’ll need to pay. While it’s harder to tackle that initial debt, this method can pay off in the long run.
The avalanche method is a great choice for someone who is more disciplined and prepared to pay off their debt quickly. If you have the right mindset and resources, this is the fastest and most efficient way to do it.
Cons
Although it’s the most cost-effective, this method doesn’t offer immediate gratification. It can take much longer before you see significant progress. This can make it harder to stay on track and motivated.
If you don’t have the money or the dedication to tackle your biggest debt up-front, this might not be the right strategy for you.
Make Your Money Work for You
Want to learn how to use debt to get rich? It isn’t always that simple, but there's more to debt than meets the eye.
The bottom line is this: There’s always risk involved when it comes to taking on new debt. But if you take on the right kind of debt and manage it well, it can help you build your wealth over time.
If you’re just getting started with your freelance career or small business, it can even be a powerful tool to invest in your future. Borrowing money up-front can give you the resources you need to start earning that money back and even generating more.
Building a freelance career can be stressful enough, which means finances and accounting might be the last thing on your to-do list. Noumena is a professional app built for freelancers and "solopreneurs" that offers support with filing taxes, financing projects, and networking with others in the industry. All of this means that you’ll h